February 18, 2011

China’s inflation dilemma

"China on Friday raised required reserves to a record 19.5 percent, adding to an increasingly aggressive effort by Beijing to stamp out stubbornly high inflation.

"Over the past four months, China has also raised interest rates three times and ordered banks to issue fewer loans in an attempt to make sure it can meet a 2011 inflation target of 4 percent."

Though rising food prices are indicted in a good many discussions of emerging market inflation these days, it is not just food, the article notes:

"Soaring food costs have driven Chinese inflation, rising 10.3 percent in the year to January and accounting for nearly three-quarters of the jump in overall prices.

"But pressures have been broadening. Non-food inflation, long subdued, rose at its fastest pace in more than a decade in January."

The Reuters piece, in my opinion, also hits on the key issue:

"Excess cash in the economy, stemming from China's trade surplus, is a root cause of fast-rising prices, prompting the central bank to use reserve requirements to lock up a bigger share of deposits and thereby slow money growth."

The real exchange rate—which, in effect, measures the value in trade of Chinese goods and services for U.S. goods and services—is rising and has been more or less continuously for some time. It is not so apparent that the real exchange rate is being systematically manipulated or controlled, and in fact there is good reason to claim that it is not (or at least not via monetary policy). Real exchange rates are about the demand and supply of real resources—things that are not over time controlled by manipulating the money supply. That reality is suggested by evidence cited in the Economist article:

"Conventional wisdom says that a stronger yuan would reduce China's current-account surplus. Yet the empirical support for this is weak. In a paper published in 2009, Menzie Chinn of the University of Wisconsin and Shang-Jin Wei of Columbia University examined more than 170 countries over the period 1971-2005, and found little evidence that countries with flexible exchange rates reduced their current-account imbalances more quickly than countries with more rigid regimes."

But if printing money does not buy you control over real stuff, it is very definitely a factor in controlling the nominal exchange rate—a measure of the value in trade of currency for currency. And there, I believe, is the crux of the problem. To keep the nominal exchange rate from rising, the People's Bank of China in effect prints yuan and buys dollars. Though this has limited impact on any real fundamentals, it is the source material for inflation. In fact, if a monetarist heart beats within you, the picture of the recent Chinese inflation experience will surely warm it:

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I am surprised that Bernanke said that inflation in Emrging Market, Middle East and Africa are from the wrong policies in those countries but actually Bernanke is the major reason of the food crises around the world inclduing America; howeverr, US inflation data is hidden by shelter slowdown. I think all political and economic crises from food and commodities hike can be solved if Bernanke admits the guilty of the upheaval around the world. I think food price hike will affect US at the end and we could see people blame the wrong monettary policy. I will see.

"The renminbi is undervalued. … It would be both in our interest and in the Chinese interest for them to raise the value of their currency."

The first sentence is irrefutable. The second is highly questionable. If China were to halt currency interventions, it may seriously reduce its growth. A "rebalancing" is inevitable, but it would be more painful under conditions of global AD deficiency.

Research arguing that currency interventions by China do not materially improve its exports and current account are akin to what is called "the doctrine of immaculate transer." I have even seen Menzie make statements that the yuan may not be undervalued.

I think a much better picture is obtained by comparing China's current situation with Japan before it relinquished capital controls.

Imported food price is higher could be attributed to the depreciation of the USD. But if measure it in another currency you could have different results. China's inflation problem is the opposite of the US, where a currency that is kept artificially weak is driving higher food prices.

Similarly it is interesting to note that if you measure the oil price in another currency, it has not risen as much. For example the Oil price in Yen is still cost at equivalent to $65 per barrel.

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"It is not hard to imagine that a few years from now the current account imbalances of the US and China will be very much smaller than they are today or even totally gone."

An advance copy of the article was provided a few weeks ago at Real Time Economics, and considerable commentary has followed since (here, here, here, and here, for example). Not surprisingly, the progress Professor Feldstein envisions has two components:

"The persistence of large current account imbalances reflects government policies that alter the savings-investment balances in both the United States and China.

"The large current account deficit of the United States reflects the combination of large budget deficits (negative government saving) and very low household saving rates. ...

"Consider first the situation in the United States. Current conditions suggest that national saving as a percentage of GDP will rise as private saving increases and government dissaving declines. Private saving has been on a rising path from less than two percent of disposable income in 2007 to nearly six percent of disposable income in 2010. The forces that caused the rise in the U.S. saving rate since 2007 could cause the saving rate to continue to rise. Those forces include reduced real wealth, increased debt ratios, and a reduced availability of credit. ...

"The reduction of the U.S. current account deficit implies that the current account surplus of the rest of the world must also decrease. While this need not mean a lower current account surplus in China, I believe that the policies that the Chinese have outlined for their new five year plan are likely to have that effect. These include raising the share of household income in GDP, requiring state owned enterprises to increase their dividends, and increasing government spending on consumption services like health care, education and housing."

Some skepticism about the probability of a substantial decline in Chinese saving rates was noted in a recent post at The Curious Capitalist, which focuses on some interesting new research that relates high Chinese saving rates to an increase in income volatility. To the extent that the increased income volatility is inherent in China's ongoing transition to a more market-based economy, substantial changes in consumer behavior might be difficult to engineer. That said, only about half of the increase in Chinese saving rates appears explainable based on natural economic forces, and the Chinese government can certainly reduce national saving of its own accord (via deficit spending). Furthermore, according to Feldstein's calculations, a relatively small decline in the Chinese saving rate could eliminate their side of the current account imbalance.

"Households have been actively deleveraging—that is, working down debt levels and saving more of their income. The savings rate has increased from a little over 1 percent in 2005 to more than 5 percent currently.

"Consumer debt as a percent of disposable income has declined markedly over the past three years after rising steadily since the 1980s. Most nonmortgage consumer debt reduction has been in credit card balances. As consumers have reduced their debt, the share of income used to service financial obligations has fallen sharply to the lowest level in a decade.

"Consumer action to reduce debt is not the whole deleveraging story. In the numbers, the decline in overall household indebtedness has been highly affected by bank write-offs. Also, banks' stricter underwriting requirements for new consumer debt have contributed to runoff.

"I expect the phenomenon of household deleveraging to continue."

Restrained consumer spending was one item on a list of three "headwinds" that President Lockhart believes will serve to restrain growth in 2011 (the other two being policy uncertainties and ongoing credit market repair). Not that this is all bad:

"First, today's headwinds to a significant degree reflect structural adjustments that will, in the longer term, place the U.S. economy on a stronger footing. The preconditions for strong future growth are reduced uncertainty, improved consumer and household finances, and healthy credit markets.

"Second, I believe the headwinds I have emphasized will restrain growth but not stop it. I fully expect growth in gross domestic product, in personal incomes, and in jobs to be better in 2011 than in 2010.

"Finally, I acknowledge the potential that economic performance this year could surprise me on the upside. Businesses, for example, are sitting on lots of cash. Cash accumulation is not something that can continue forever, particularly in the case of public companies. It may not take much weakening of headwinds to unleash some of the economic forces that thus far have been bottled up."

Though faster progress would be welcome—particularly with respect to job creation—the Lockhart and Feldstein commentary makes it clear there is a delicate balance between resolving the short-run pain and setting up the longer-term gain.

By Dave Altig
Senior vice president and research director at the Atlanta Fed

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Is there really much evidence of consumers actively deleveraging? So far, the vast majority of deleveraging can be accounted for by defaults and write-downs. Though, I guess walking away from a mortgage could be described as actively deleveraging... ;-)

One other point, can it be determined how much of the fall in the debt service ratio is due to a decrease in interest rates and how much to a fall in debt-to-income levels? I tried looking into this, but it seemed like guess-work.

From 1982 to 2008, debt-to-income levels rose as interest rates generally fell, but not enough to offset the rise in debt levels, so the DSR rose. And this went on way longer than anyone in 1982 would have thought likely.

If we accept a moderately optimistic scenario of continual moderate growth, interest rates will likely begin rising in a year or so. What if we are entering a period of continuing falls in debt-to-income levels, rising rates and falling DSR?

The deficit is not a recent phenomena , it has just exploded in the past 5 to 7 years. Americans unforunately do not have the capacity to save more. Poor job market means less earnings which in turn means less saving. If people are not earning they eat into their nest eggs to cover expenses. Somehow doubt that this deficit will simply ease away.

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June 21, 2007

Dark Matter By Any Other Name

... The United States miracle of the 1990s was that our productivity began growing faster than that of other countries, even though we were the richest to start with...

To explain the experience in the United States, one would have to believe that Americans have some better way of translating the new technology into productivity than other countries. And that is precisely what [London School of Economics] Professor [John] Van Reenen’s research suggests.

His paper “Americans Do I.T. Better: U.S. Multinationals and the Productivity Miracle,” (with Nick Bloom of Stanford University and Raffaella Sadun of the London School of Economics) looked at the experience of companies in Britain that were taken over by multinational companies with headquarters in other countries. They wanted to know if there was any evidence that the American genius with information technology transfers to locations outside the United States. If American companies turn computers into productivity better than anyone else, can businesses in Britain do the same when they are taken over by Americans?

And in the huge service sectors — financial services, retail trade, wholesale trade — they found compelling evidence of exactly that. American takeovers caused a tremendous productivity advantage over a non-American alternative.

When Americans take over a business in Britain, the business becomes significantly better at translating technology spending into productivity than a comparable business taken over by someone else. It is as if the invisible hand of the American marketplace were somehow passing along a secret handshake to these firms.

There is a large difference between our view of the US as a net creditor with assets of about 600 billion US dollars and BEA’s view of the US as a net debtor with total net debt of 2.5 trillion. We call the difference between these two equally arbitrary estimates dark matter, because it corresponds to assets that we know exist, since they generate revenue but cannot be seen (or, better said, cannot be properly measured)...

At least three factors account for the accumulation of dark matter. The first refers to foreign direct investment (FDI). Consider a simple example. Imagine the construction of EuroDisney at the cost of 100 million (the numbers are imaginary). Imagine also, for the sake of the argument that these resources were borrowed abroad at, say, a 5% rate of return. Once EuroDisney is in operation it yields 20 cents on the dollar. The investment generates a net income flow of 15 cents on the dollar but the BEA would say that the net foreign assets position would be equal to zero. We would say that EuroDisney in reality is not worth 100 million (what BEA would value it) but four times that (the capitalized value at our 5% rate of the 20 million per year that it earns). BEA is missing this and therefore grossly understates net assets. Why can EuroDisney earn such a return? Because the investment comes with a substantial amount of know-how, brand recognition, expertise, research and development and also with our good friends Mickey and Donald. This know-how is a source of dark matter. It explains why the US can earn more on its assets than it pays on its liabilities and why foreigners cannot do the same. We would say that the US exported 300 million in dark matter and is making a 5 percent return on it. The point is that in the accounting of FDI, the know-how than makes investments particularly productive is poorly accounted for.

... we review the argument that the United States holds large amounts of intangible assets not captured in the data—assets that would bring the true U.S. net investment position close to balance. We argue that intangible capital, while a relevant dimension of economic analysis, is unlikely to be substantial enough to alter the U.S. net liability position.

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June 11, 2007

One Savings Glut That Carries On

China's monthly trade surplus soared 73% in May from a year earlier, a state news agency reported Monday, amid U.S. pressure on Beijing for action on its yawning trade gap and the possibility of sanctions.

Exports exceeded imports by $22.5 billion, the Xinhua News Agency said, citing data from China's customs agency. That figure, close to the all-time record high monthly surplus of $23.8 billion reported in October, came despite repeated Chinese pledges to take steps to narrow the gap by boosting imports and rein in fevered export growth. The report gave no details of imports or exports.

The U.S. government has been pressing Beijing for action, especially steps to raise the value of the Chinese currency. Critics say the yuan is kept undervalued, giving Chinese exporters an unfair advantage and adding to the country's growing trade gap.

Apparently, the U.S. Senate is about to officially jump into the yuan-peg fray. From Bloomberg:

The U.S. Senate will introduce a bill this week to pressure China to strengthen its currency, the Financial Times said today, citing unidentified people close to the situation.

The market, on the other hand, suggests that maybe things aren't so straightforward:

The gap may increase pressure on China to let the yuan appreciate to reduce tensions with trading partners and cool the world's fastest-growing major economy. The currency today had its biggest decline in 10 months and has reversed gains made in May when Chinese and U.S. officials met for trade talks in Washington...

The yuan declined 0.2 percent to 7.6691 against the U.S. dollar at 4 p.m. in Shanghai today, the biggest one-day fall since Aug. 15.

The currency has strengthened 7.9 percent since China scrapped a 10-year peg to the dollar and revalued the currency in July 2005. The 0.74 percent monthly gain in May was the biggest since the end of the fixed exchange rate.

I'm not sure what the story is there, but Nobel Prize winner Robert Mundell warned this weekend that too much pressure on the Chinese may not imply an appreciating yuan. From the Wall Street Journal (page A9 in the weekend print edition):

... in the unlikely event that the yuan were suddenly made fully convertible, Mr. Mundell predicts that the value of the currency would fall, not rise. Many Chinese savers would want the security of keeping at least some portion of their wealth in foreign currency and would convert quickly, worried that the government might slam the door shut. This might become a self-fulfilling prophecy. In the U.K. in 1947, the Bank of England saw its reserves evaporate in a matter of weeks, and reinstated capital controls. The movement to full convertibility is fraught with danger and must be approached cautiously.

Meanwhile, yet another Nobel Prize winner, Michael Spence, suggests there is something much deeper in play than mere currency policy. From China Daily:

China has been in a high growth mode since it started economic reforms in the late 70s. Its almost three decades of high growth is the longest among the 11 high-growth economies in the world and part of "a recent, post-World War II phenomenon". And the Chinese economy will sustain its fast growth for at least two more decades...

The high levels of savings and investments both in the public and private sectors, resource mobility and rapid urbanization are the important characteristics of China's high growth, says Spence, who is also the chairman of the independent Commission on Growth and Development. The commission was set up last year to focus on growth and poverty reduction in developing countries. China's saving rate of between 35 to 45 percent is among the highest despite the relatively low level of income of its people. Resource mobility has generated new productive employment to absorb surplus labor in a country where 15-20 million people move from the rural areas to the cities every year.

The most important feature of sustained high growth is that it leverages the demand and resources of the global economy, says Spence. All cases of sustained high growth in the post-War period have integrated into the global economy because exports act as a major high-growth driver.

Enumerating the reasons why the Chinese economy will sustain its high growth rate for another two decades, he says: "There are basically two reasons. One is that there is still a lot of surplus labor in agriculture. The engine for high growth is still there. The second is that the Chinese economy has diversified very rapidly. It's quite flexible and entrepreneurial."

Spence clearly believes that the Western complaints of too low a value for the Chinese currency and too high a surplus in its trade balances will self-correct, with a little help from government policy:

The only way to stop China's high growth would be to shut the economy off from the rest of the world. "It's just not going to happen." Even 20 years later, China will continue to grow because its currency will appreciate, helping raise the income level and increase the wealth of the people...

... To balance the huge trade deficit, Spence hopes China would boost domestic consumption and bring down the saving rate.

He acknowledges, though, that the relatively high-income younger generation is spending more despite the fact that East Asians traditionally are good at saving. A solution to the trade imbalance could also be found by increasing social security and the pension system, making them available to everybody, improving the medical coverage in the rural areas and making education at all levels affordable.

China Export-Import Bank (EximBank) is set to issue 2 billion yuan (US$261 million) in yuan-denominated bonds in Hong Kong this month, making it the first Chinese lender to do so, sources told Reuters on Monday.

Exim Bank is to sell the 3-year bonds only to institutional investors, an investment banking source said, adding that the bank would decide on the yield later.

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» News of the World #38 from Economic Investigations
Elsewhere Paying It ForwardThe Economics of Altruism GMU Econ bloggers, a (non-exhaustive?) summary. Can One Be a Classical Liberal and Really Believe This?. Wladimir Kraus has a short essay arguing that government produces nothing... [Read More]

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Mundell's comments make no sense to me. Why would chinese citizens convert a rising Yuan to a falling USD or falling Euro? Security? If chinese citizens are so concerned with security, why are they pumping money into equities at an alarming rate?

Those who think the Yuan is undervalued can never explain why the PBoC have to excahnge an awful lot of Yuan for USD to keep the currency peg. It's never the other way around.

Mundell also went for the "everything all at once" approach. It doesn't have to be that way. The yuan can be allowed to float without allowing full convertability. That has been done before, has it not?

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June 09, 2007

Like Ben Said

The trade deficit, ex-petroleum, appears to have peaked at about the same time as Mortgage Equity Withdrawal in the U.S.

"Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit. To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account."Alan Greenspan, Feb, 2005

... Declining MEW is one of the reasons I forecast the trade deficit to decline in '07. And a declining trade deficit also has possible implications for U.S. interest rates; as the trade deficit declines, rates may rise in the U.S. because foreign CBs will have less to invest in the U.S.. This is why I forecast rates to rise in '07.

I think that CR has the causation running from the housing market to the trade deficit, but as always there is another interpretation. I take you back to one of my favorite Fed speeches of all time, from the current Fed chairman:

What then accounts for the rapid increase in the U.S. current account deficit? My own preferred explanation focuses on what I see as the emergence of a global saving glut in the past eight to ten years...

The current account positions of the industrial countries adjusted endogenously to these changes in financial market conditions. I will focus here on the case of the United States, which bore the bulk of the adjustment...

After the stock-market decline that began in March 2000, new capital investment and thus the demand for financing waned around the world. Yet desired global saving remained strong. The textbook analysis suggests that, with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving. Indeed, real interest rates have been relatively low in recent years, not only in the United States but also abroad. From a narrow U.S. perspective, these low long-term rates are puzzling; from a global perspective, they may be less so.

The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low--and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower...

The direct implication, of course, was that the reversal of U.S. current account deficits would likely be associated with higher real interest rates, a weakening of foreign-capital financed investment, and higher saving in the U.S. (of which a slowdown in mortgage equity withdrawals could be a part). It is worht noting that Chairman Bernanke was decidedly less than sanguine about the consequences of such adjustments:

... in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

Whether or not Mr. Bernanke believes that we find ourselves in the process of meeting those burdens I cannot say. But those who buy the global saving glut story -- as I do -- have acknowledged all along that the day of adjustment would look pretty much like it does at the moment.

The current account deficit may narrow because our demand for foreign credit weakens or because the supply of that credit weakens. In both cases, the implication for the dollar is that it declines, other influences held unchanged. However, the implication for interest rates depends critically on whether the reduced external borrowing reflects demand- or supply-side influences. A deceleration of MEW in resopnse to a less robust housing sector -- assuming it is even relevant -- would be a demand-side development and could not generate upward pressure on interest rates. Calculated Risk has this point wroong.

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The United States ran a record trade deficit in 2006 for the fifth consecutive year, the Census Bureau reported Tuesday in an announcement that quickly reignited the dispute between the Bush administration and Democrats over the value of past and future deals lowering trade barriers.

The bureau said that the trade deficit, or gap between what the United States sells abroad and what it imports, reached a new high of $763.3 billion last year, a 6.5 percent increase over the year before. The deficit was fueled by the continuing American need for foreign oil and imports of consumer goods from China and other countries.

The fact that the two deficits are moving in opposite directions is not really anything new:

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While it is gratifying to see a graph indicating a decrease in the rate of increase in the cumulative Federal budget deficit, the continuing rate of increase in trade deficit is much more fundamental. One speaks to the Federal government deficit while the other speaks to a looming economic deficit.

The real question is "how long the US can continue to consume an excess of goods, produced off-shore, and maintain a vibrant, balanced domestic economy?".

Macro-economic theory clearly predicts that, at the peak of an economic boom, the Federal deficit should decline. We can all take one breath that, finally, the rate of growth of the deficit has, at least temporarily, declined. Okay, back to the wait for the other shoe to drop.

Macro-economic theory also predicts that, should massive losses of high paying jobs and key industries to Foreign competition bring on a recession, the deficit will increase.

Please be wary of the budget deficit numbers. They do not include deficits incurred by war spending on Iraq and Afghanistan. These are "off budget" items which are not show in the normal quarterly budget deficit numbers. Including this would spread out about $500B in deficit spending over the period from 2003-2006.

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September 26, 2006

Yesterday I nodded approvingly to the following remarks on the consequences of trade and current account deficits from Nouriel Roubini, as recounted by the Wall Street Journal:

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future."

Reader Jim K responded...

"Your standard of living is going to be reduced unless you work much harder...."

Doesn't that depend on what we do with the proceeds of all this borrowing? If it is invested productively, then we won't have to reduce our consumption.

... and reader Gerald MacDonnell seconded the objection:

I agree with Jim. If anything he understates the point. The question boils down to what returns we earn on capital investment here. The tendency for capital deepening to raise labor returns is independent of who owns the capital. And even the net financial return seems likely to rise, despite the rising net tribute paid to foreigners.

Well, those are mighty fine points, and I was mighty remiss in not making them. So then, is it likely true that the sharp increase in the U.S. current account deficit that commenced in about 1997 has deepened the capital stock beyond what it otherwise would have been? knzn responds to Jim and Gerald's comments:

Although the other commentators make theoretically correct points, I think they are wrong empirically. Over the past few years, the US capital surplus (i.e., “borrowing”) has mostly been invested in residential real estate, which is not nearly as productive a use as one might hope for. Residential investment won’t do a whole lot to raise labor returns in the future.

Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

This is a really intriguing question: Should we care if investment takes the form of physical capital that will ultimately be devoted to producing goods and services sold in markets, as opposed to physical capital that will ultimately be devoted to "home production" (that is, the manufacture of all those things that make us happy that households create for themselves)?

I'm not so sure. It would be true that increased quantity and quality in residential housing would do little to raise productivity in market activities, but surely it must raise productivity in home production. It would also be true that devoting more resources to home production means fewer resources for market production. In other words, if we decide to enjoy the "output" a larger yard, a more inviting family room, a gourmet kitchen,or whatever, we may have to cut down on our consumption of other things. But so what? That's a choice that individuals make all the time, and the truth is that economists don't have much to say about whether it is a good thing or a bad thing: De gustibus non est disputandum.

I can think of at least a couple of reasons to not be indifferent about the market/home investment distinction. For one thing, as mentioned by Mr. Bernanke, the deck is already stacked in favor of housing via tax incentives, institutions like Fannie Mae, and so on. A boom in a distorted market may not be such a great thing.

Perhaps more important from the financial stability point of view, home production is, by definition, non-tradable, so investment in housing has a limited capacity to directly generate the means to pay back foreigners who lend to us. That's the sense in which I was agreeing with Roubini and knzn -- the payback would have to come in the form of reducing our own consumption of market goods (again, below what it would otherwise be). Again, that is not a bad thing per se, but there is some possibility that this makes the whole set of transactions riskier from the point of view of the lenders, raising borrowing costs and inducing market volatility. There is yet scant evidence that this is the case, but I suppose it is a possibility.

Others may have additional reasons for worrying about a shift from market to home production. I'd like to hear them. But for now, I take the point that conclusions about the "problem" of the current account deficit are not clear cut. Consider me duly chastened.

UPDATE: Be sure to read the very thoughtful contributions to the comment section.

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A few points:

1. The textbook separation of "sources and uses" of funds (i.e. the fungibility of money) means that statements like "the US capital surplus (i.e., 'borrowing') has mostly been invested in residential real estate" can't really be justified. Presumably the funds go to some combination of C, I, and G that we'll never know.

2. To the extent the funds do augment the housing stock, I would argue that the main impact is temporary. If we're left with "too much" housing then we will build less in the future, and use our resources to do something else (hopefully more productive). I don't see why the effects would be permanent.

3. If we have for some reason moved to a permanently higher share of resources devoted to housing, then, as you say, we will have to have less of other stuff, but that would be the result of our preferences. The tax distortions have been there for a long time, and haven't increased, so they can't be responsible (though it's conceivable rumors of their demise could be pushing some investment forward).

Jim -- We can compare changes. And at the margin, the post-2000 increase in the current account deficit has been associated with:

a) a fall in household savings (i.e. a rise in consumption v income)
b) a fall in government savings (i.e. the tax cuts/ war/ etc)
c) a rise in in residential investment
d) a fall (relative to 2000 levels) in non-residential investment. business inv. has picked up a bit since its lows, but it remains well below its late 90s level.

so I think it is fair to say the recent surge in external debt has been associated with a surge in consumption/ residential investment.

that is my concern: external debt is not a claim on the overall US economy. It is a claim on the external portion of the US economy -- i.e. the United States ability to generate enough export revenue (and revenue from US investment abroad) to pay our external debts and afford the imports we want/ need. it isn't obvious that the surge in debt recently has been associated with a surge in our future capacity to generate exports.

that said, in fairness, it has been associated with a surge in the market value of US external assets. that is more tied to the surge in non-US equity market valuations/ currency moves than any increase in the cash revenues produced by US investment abroad, but it is worth noting.

Dave -- this applies more to your preceding post than your current post, but without jumping into scare mongering, i do think that there is some risk of a significant increase in the US income deficit in the near future. I laid out my thinking in a recent post, but the key points include:

a) by my calculations, a rise in the average interest rate on US external borrowing to around 5% (v a bit over 4% in the first half of 2006) would lead to a deterioration of around $60b in the US income balance.

b) barring any offsetting rise in the income stream from US investments abroad relative to foreign investment in the US, ongoing currnet account deficits in the $900b-1,000b range imply -- depending on the marginal cost of US borrowing -- an increase of roughly $50b in the US interest bill per year. Long-term rates are under 5% on treasuries, but if you add in short-term borrowing and MBS/ agencies, i think the average cost of funds for the US is a bit above 5% right now at the margin.

c) a 1% increase in the average int. rate on US borrowing would increase the US interest bill by about $40-50b a year. That comes from higher interest costs of the portion of the US external balance sheet that is financed with debt -- i.e. the debt for equity swap (higher rates on the debt, no higher returns on the equity) and the US net debt position. those positions currently are in the $4.5 trillion range.

I am assuming that the averate int. rate on Us lending would rise commensurately, so the portion of US external borrowing that is matched by lending would not contribute to the deterioration.

add it up, and it seems to me that a significant deterioration is likely simply from the normalization of US interest rates on the external side, something that is playing out a bit more slowly than I expected....
I would consequently expect an income deficit of around $100b next year, even if nothing "bad" happens -- just from an increase average US extenral interest rates toward 5%.

Plus, as the US net debt position deteriorations/ a growing share of US equity investment abroad is financed with debt, the US exposure to an interest rate shock rises.

Seconding Brad Setser's comment to Jim K, I think that whether, "de gustibus non est disputandum", household investment of borrowed funds is as "good" as any other, depends on the certainty and ease with which the borrower will be able to service the debt. It's important to note that from an external lenders perspective, investment in nontradables is indistuinguishable from consumption [*].

Normatively, a borrow who borrows to finance "in kind" returns, as might be supplied by a nice home, a vacation, or a good meal on a credit card, should not be criticized, so long as the burden she is taking on is one she can reasonably service. But a borrower whose capacity to its service her debt-load is in doubt ought to be criticized for such borrowing, as investing to secure in-kind returns without exchange value leaves ones external balance sheet encumbered by an additional liability with no corresponding asset, damaging the position of creditors.

Exactly the same argument applies to the United States' use of steep credit lines to finance consumption and nontradable investment. The magnitude of the United States debt load and the pace of its increase calls into question our ability to service our obligations (without partially defaulting by devaluing credit claims). Under these circumstances, borrowing for in-kind returns is putting other people's capital at risk for benefits they cannot share. It is behavior as much deserving of criticism and a heavily indebted low-wage worker putting a trip to Vegas on the fifth credit card.

One might ague that the "dollar is our currency, but their problem", so these concerns are overstated. I think that's right as far as it goes. But it does not go very far. The US has a capacity that overleveraged workers don't have, to devalue the claims against it with much less disruption than an individual declaring bankruptcy. The US might well end up having gotten lots of in-kind returns for pennies on the dollar, by playing and winning a zero-sum financial game with its foreign creditors. But zero-sum games are not what trade is supposed to be about. If the US "wins" this way, it will damage not only its future credibility as a borrower, but the case for trade as a positive sum enterprise with benefits for all. It is those who currently championing this moment's "free trade" who are most seriously damaging the long-term case for trade as economists like to envision it.

That was much more of a rant than I intended... I just don't think you should feel "chastened" for your previous expressions of worry, and speaking of in-kind returns, I hope you are hardly chaste at all!

---

[*] One could quibble -- to some degree nontradables can be considered an investment in future tradables production, as no tradables could be produce if American workers had no homes. But this is analogous to noting that American workers couldn't produce if they didn't buy food. We still mostly consider food expenditures consumption, not investment, and rightly so since we spend dramatically more than the minimum required to sustain production with some spartan lifestyle. Same argument goes for housing.

Brad, Forget the "rise in Residential Investment". We ALL now know it wasn't fundamentals that elevated house prices to these absurd levels. Our housing Bubble was driven by political shenanigans & rampant investor speculation, income can't support it & it WILL be reversed.
Tim Iacono reminds us this morning of the dilemma BB's Fed faces. Is Fed credibility at stake because of BB's misread & speak straight to us about our future prospects? (It's pretty obvious the Bond market doesn't think so, it's betting Bernanke works for them & will start major easing SOON.) Here's an excerpt from Iacona, link follows.
"From the fine blog of Calculated Risk comes this tidbit from last year where then-White House economic advisor Ben Bernanke offered his thoughts on the price of real estate.
Friday July 29, 2005
Bernanke: House Prices Unlikely to Decline.
Bernanke was on CNBC today. From Reuters:
Top White House economic adviser Ben Bernanke said on Friday strong U.S. housing prices reflect a healthy economy and he doubts there will be a national decline in prices.
"House prices have gone up a lot," Bernanke said in an interview on CNBC television. "It seems pretty clear, though, that there are a lot of strong fundamentals underlying that.
"The economy is strong. Jobs have been strong, incomes have been strong, mortgage rates have been very low," the chairman of the White House Council of Economic Advisers said.
The pace of housing prices may slow at some point, Bernanke said, but they are unlikely to drop on a national basis.
"We've never had a decline in housing prices on a nationwide basis," he said, "What I think is more likely is that house prices will slow, maybe stabilize ... I don't think it's going to drive the economy too far from its full-employment path, though."
Is it too early to start talking about the "Bernanke Put"?
The resurrection of this quote is certainly not a good indication of Mr. Bernanke's ability to predict the future - the timing of this assurance is particularly embarrassing. Graphically, with a little help from the Northern Trust, the situation looks like this:
Ironically, it has been almost exactly one year from when the Fed chief's prediction was offered. The report of two days ago, in which median home prices were seen to be declining on a year-over-year basis, was the very first full-year reporting period where Mr. Bernanke's assurances could have been put to the test and, unfortunately, the new Fed Chairman's advice looks to be as bad as the old Fed Chairman's."
My comment is that so far our Fed has refused to reverse its Banks' ridiculously loose mtg. lending criteria. Further, it has refused to state clearly that we can NOT go on expecting monetary policy to be the cure-all for profligate excesses of the Administration, GSEs, Congress, and carefree consumers. The Fed MUST tell the world, Business Cycles are painful but necessary.http://themessthatgreenspanmade.blogspot.com/2006/09/housing-report-that-mattered.html

For years I have rearanged the BEA savings and investment data
into a sources and uses presentation --it primarilly involves moving the fed deficit to uses rather then negative savings --and have found that it really makes the audience understand what is happening much easier.

For example, one of the observations that falls out of a "sources and uses" table is that in the 1990s boom foreign investment and the federal surplus financed about half of the capital spending boom.

Now this same presentation really makes it clear that the foreign investment is being used largely to finance the federal deficit and/or consumption, not investment.

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September 25, 2006

The End Of Dark Matter?

Exactly how the U.S. has managed to load on so much debt without seeing its net payments rise remains something of a mystery. Even in the second quarter, the U.S., in effect, was paying only a 0.4% annualized interest rate on its net debt. "It's still quite a good deal," says Pierre-Olivier Gourinchas, an economics professor at the University of California, Berkeley.

In a recent paper, Harvard economists Ricardo Hausmann and Federico Sturzenegger went so far as to suggest that the U.S. might not be a net debtor at all. Instead, they surmised, the U.S. might actually have income-producing assets abroad, such as know-how transferred to foreign subsidiaries, that have evaded measurement -- assets they call "dark matter," after a similarly elusive quarry in physics. Mr. Sturzenegger says the latest data haven't changed his view.

Most economists, however, see a more prosaic explanation: Foreigners have been willing to accept a much lower return on relatively safe U.S. investments than U.S. investors have earned on their assets abroad. Take, for example, China, which since 2001 has invested some $250 billion in U.S. Treasury bonds yielding around 5% or less -- part of a strategy to boost its exports by keeping its currency cheap in relation to the dollar.

Well, to be fair to Hausmann and Sturzenegger, that interest rate differential was part of their story. Much of the debate was actually about the meaning of that differential: Is it some inherently superior aspect of the US economy that drives foreigners to pay a premium for our financial assets? Or is it the agenda of, for example, the People's Bank of China, pursuing policies that are more about internal political objectives than market fundamentals?

In any event, the Journal article suggests that, just maybe, we are seeing the beginning of the end:

As interest rates rise, America's debt payments are starting to climb -- so much so that for the first time in at least 90 years, the U.S. is paying noticeably more to its foreign creditors than it receives from its investments abroad. The gap reached $2.5 billion in the second quarter of 2006. In effect, the U.S. made a quarterly debt payment of about $22 for each American household, a turnaround from the $31 in net investment income per household it received a year earlier...

The gap is still small within the context of the $13 trillion American economy. And the trend could reverse if U.S. interest rates decline. But economists say America's emergence as a net payer illustrates an important point: In years to come, a growing share of whatever prosperity the nation achieves probably will be sent abroad in the form of debt-service payments. That means Americans will have to work harder to maintain the same living standards -- or cut back sharply to pay down the debt.

The article contains a lot of comments hinting at a deep instability that seem, to me, a bit over the top:

If the trend persists, it could also raise concerns about the nation's creditworthiness, putting pressure on the U.S. currency. "It's an additional challenge for the dollar," says Jim O'Neill, chief economist at Goldman Sachs in London...

Among economists' biggest concerns, though, is the fast pace at which the U.S. is accumulating new debt. As that leads to larger interest payments, it will make the current-account deficit harder to control -- a vicious cycle that could accelerate if worried foreign investors demand higher interest rates to compensate for the added risk...

"You end up having to pay more and borrow more," says the University of California's Prof. Gourinchas. "Things could get out of hand very quickly."

And this statement just seems wrong:

The size of the nation's debt payments matters because it represents a share of income that American consumers, companies and government won't be able to spend or save. The higher the debt payments, the harder it will be for the U.S. to prosper.

Any rapid change in capital flows could, of course, be disruptive in the short run, but a lot of borrowing by the country means the same thing as it does for you: Accumulated debt doesn't stop you from earning income, it just limits your ability to spend it. Nouriel Roubini puts his finger on what it all really means:

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future."

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"Your standard of living is going to be reduced unless you work much harder...."

Doesn't that depend on what we do with the proceeds of all this borrowing? If it is invested productively, then we won't have to reduce our consumption. If it's consumed or invested unproductively we will. That's the same as with any other kind of borrowing. The presumption of all these dark warnings is that we are doing the latter, but I don't see what that's based on.

I agree with Jim. If anything he understates the point. The question boils down to what returns we earn on capital investment here. The tendency for capital deepening to raise labor returns is independent of who owns the capital. And even the net financial return seems likely to rise, despite the rising net tribute paid to foreigners.

Although the other commentators make theoretically correct points, I think they are wrong empirically. Over the past few years, the US capital surplus (i.e., “borrowing”) has mostly been invested in residential real estate, which is not nearly as productive a use as one might hope for. Residential investment won’t do a whole lot to raise labor returns in the future. Moreover, if you compare investment and savings levels (as derived from the national accounts) to historical averages, you would have to say that much of the surplus has been consumed.

On the other hand, we don’t really know the answer to the counterfactual, how much would have been consumed and invested if we hadn’t been borrowing so much. And one could even argue that borrowing for consumption was a reasonable thing to do given expected productivity growth.

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini,....etc.
"No argument here." ???

I beg to differ, change the word "harder" to "more efficiently" and I might concur, add "Enthusiastically" to that maxim, and I will concur with enthusiasm. Engineers tend to see accountants as puppy dogs, trying to catch their tails, running round in ever decreasing circles till they fall over, panting with a big innocent smile on their face! A 'for instance' as far back as I can remember (pre-1960's) Engineers have scratched their heads in total perplexity at why we put sticky oil in pipes and pump that sticky oil hundreds if not thousands of miles at huge labour. Madness! Engineers would bag the oil into sausages, place each sausage ballel of oil into a magnetic levitation "PIG" and then fly the oil at break neck speed down a much smaller evacuated tube. Deaserts need water, seawater evaporates in the deasert...slightly obvious statement....as the "PIGS" brake at each end of their jourlney, the momentum is converted into electricity...which in turn propells the out-going "PIGS". Oil arrives at a Sea-Port, and Sea-Water arrives at the Oil Well. Sea Water turns to Fresh Clean Potable water and Sea-Salt. which is a highly desireable and marketable commodity on it's own.

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How To Interpret the Trade Deficit?

This month’s data suggests that the economy hasn’t slowed enough to end all import growth. Non-oil goods imports rose to $130b. Barring the recession Nouriel is now forecasting, I would expect non-oil imports to continue to trend up over the course of the year.

... but Menzie concludes...

One noteworthy point is that the non-oil trade deficit has continued its stabilization in nominal terms (as mentioned in my post on the May 2006 trade figures as well as this post based on the NIPA data), so in terms relative to GDP, it has fallen.

The [Bloomberg article] cites the continued strength of the consumer. The month-on-month figures don't support that contention -- although the quarter-on-quarter growth rates would indicate some growth.

... and CR seems to agree:

It appears the trade deficit, excluding petroleum, might have stabilized... This might indicate a slowing U.S. economy and is consistent with a slowdown in the U.S. housing market.

... While it seems reasonable to think that the upward trend in exports will resume in August and September, the wider July gap makes it more likely that the trade accounts will exert a bit of a drag on [third-quarter] GDP growth for the first time this year.--Nomura Economics Research

Based on the much-larger-than-expected deterioration in the overall trade gap, we now see net exports subtracting 0.4 percentage point from [third quarter] GDP growth, down from our prior estimate of a 0.3 percentage point addition....--Morgan Stanley U.S. Economics

Well, all else fixed I guess that's so, but there is also this, from the aforementioned Bloomberg article:

A growing appetite for Japanese electronics and clothing from China suggests American consumers are still spending even as the housing market sags, and that the U.S. economy needn't rely on foreign demand to fuel the expansion...

"As long as the consumer is relatively healthy, we're going to see a wide trade deficit,'' said Stephen Stanley, chief economist at RBS Greenwich Capital in Greenwich, Connecticut.

And, presumably, that would be the sign of a relatively healthy economy. Is it possible we should be adding points back on to our growth forecasts?

What does this all add up to? Pretty simple,really. The economic environment is a total murk, and everyone is just guessing. In other words, nothing unusual.

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If you look at the real consumption numbers it is hard to find many signs of weak spending outside of autos.

Since 1990, autos and energy have accounted for some 10% to 11% of total personal consumption expenditures (PCE) and since 2002 as energy has grown from 4.2% to 6.1 % of PCE auto sales have slipped from 6.3% to 4.8% of PCE—almost a one-for-one adjustment. It looks like the adjustment to higher oil prices has been almost completely limited to autos.

For example, while real retail sales growth has slipped to some 2%, excluding autos it is still
8.7% -- one of the largest spreads I have ever seen. Real PCE excluding autos and energy is still growing at a 6.25% rate.

Meanwhile, real nonoil imports are still growing at a 7.1% rate as compared to the recent low point of some 5.8% in August 2005.

1. Growing transference of higher technology production to China/Asia. In other words, we're going to be importing a wider range of goods from China/Asia/wherever else.

The growth in offshoring will continue under current U.S. trade policy, currency valuation regimes, and transnational corporate decisions. Hence, import type goods growth or product spread will increase.

2. What's the status of outstanding consumer credit right now? Should be rising, right? Go back to school expenditures and so forth...

In looking at nominal retail sales do not make the mistake of trying to deflate by the CPI to convert to real numbers.The deflator for GAFO sales -- department store type merchandise -- is running at a
minus 2.3 rate year over year and minus 3.6% on a 3 month basis.

This implies that when WMT reports 2-3% same store sales gain the real gain is more like 5%-6%.

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April 12, 2006

The Deficits Move in Opposite Directions -- For Now

The dollar touched a more than one
week high against the euro and strengthened versus the yen after
the U.S. trade deficit narrowed more than forecast in February. The trade gap, the amount by which imports exceed exports,
fell 4.1 percent $65.7 billion from a record $68.6 billion in
January, led by a decline in Chinese imports...

A separate report showed the U.S.
budget deficit gap widened last month to $85.5 billion in March,
from $71.2 billion in the same month last year.

So, one deficit rises and the other falls? Maybe not. Both Brad Setser and The Nattering Naybob point out that China's trade surplus grew in March, on a strong expansion in exports. And Menzie Chinn notes that the March (and April) surge in oil prices does not bode well for sustaining the February decline in U.S. imports. The guessing is that when the March trade numbers are revealed, the two deficits may look like twins again.

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